How The U.S. Department Of Energy Could Destroy The Oil Market

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Summary

U.S. Department of Energy releases “Long-Term Strategic Review of the U.S. Strategic Petroleum Reserve” report.

This recommendation from the agency could decimate the price of oil.

The reasoning being the recommendation and what it means for the oil prices.

Policy changes by the U.S. government and what it means for oil.

Click to enlarge

source: Wall Street Daily

The U.S. Department of Energy recently released its "Long-Term Strategic Review of the U.S. Strategic Petroleum Reserve" report, and it on major recommendation which in my view, depending on how it would be implemented, would devastate the oil market, and by extension put enormous pressure on the price oil - at least for the short term.

To understand this, investors need to understand the importance of U.S. inventory levels on the price of oil, and how that has been on of the key metrics watched by oil traders over the last few months. I think it has had more impact on oil prices than any other metric, although it's obviously connected to the supply/demand equation.

As to the seemingly benign guidelines offered in the report, the U.S. Department of Energy said it wants to see U.S. inventory levels cut from the current 700 million barrels to a range of 530 million to 600 million barrels of oil. Depending on the end result, it would mean U.S. oil stockpiles could drop by as much as 170 million barrels. That oil has to go to the market.

This appears to be a policy change by the U.S., as it follows on the footsteps of the EIA reducing the amount of U.S. inventory levels by a little over 30 million by excluding "crude oil lease stocks in the U.S. total commercial crude oil inventory data series." That's just another way of saying even though the oil is out of the ground and in storage, it won't be counted until its transported to "official" storage farms.

I have no doubt this is definitely a move to limit the impact of U.S. inventory levels on the market.

Why the changes

As already mentioned, the key reason for the move to officially lower U.S. oil inventory levels is in order to relieve some of the pressure on the price of oil by providing the illusion of it being drawn down. That's why the first stage of the process is to no longer count crude stored on leased lands, as if the oil isn't going to be delivered to the market.

This was an easy step because it requires nothing more than rearranging some digits on a ledger. The result is an immediate 30+ million barrel decline in U.S. stockpiles.

Most investors won't be fooled by the change, but over time, when the weekly inventory levels are released and compared with past levels, it gives the appearance of improvement by market forces, rather than the artificial numbers as a result of changes in how the agency will measure inventory.

To me this is obvious, and again, over time the overall purpose is to give the impression of lower stockpiles, although there is an offsetting factor that could frustrate the initiative.

The risk in lowering U.S. oil inventory levels artificially

The immediate impact of lowering the U.S. inventory level, beyond not counting oil produced and stored on leased land, is it will deliver millions of barrels of oil to the market, which has the high probability of crushing the price of oil.

What this suggests to me is, if this is how it plays out, is the U.S. government is willing to allow the country and the oil industry to suffer some fairly prolonged short-term pain, in order to produce what it perceives as long term gain.

When I say "prolonged short-term pain," I mean it isn't only going to be for a month or two, it could last a period of several months, up to as long as 6 months, depending on how quickly the oil is released to the market. If it's done quickly, it will devastate the price of oil, if it's done incrementally, it'll still push oil prices down, but not at the levels it would if it was released to the market all at once. Either way, it will have a strong effect on the price oil; I see it lasting for at least 6 months.

It looks like the Department of Energy thinks once the inventory is cleared to the desired levels, it'll remain in that range for the foreseeable future. I think that's wrong thinking because there is no doubt the U.S. shale industry will remain resilient, and will gradually add oil to the overall supply. If that's the case, even if the government wants to maintain stockpiles in a specific range, it means the oil above those levels will be pushed onto the market whether or not there is demand for it. That could pressure the price of oil for a long period of time, until the policy is changed or global demand growth finally start to outpace supply growth.

In other words, this could very easily backfire, frustrating the efforts after enduring some strong price pain from the additional supply brought to the market. As with many unintended consequences arising from government interference in markets, this will probably end up being a complete disaster.

The depth of the failure will be determined by how fast demand for oil grows. All indicators are the global economy is quickly slowing down, and the pace of the demand for oil is moving down in conjunction with it.

The one positive

There is one part of the narrative that could be considered a positive, and that is the idea the emergence of the U.S. as an energy powerhouse has lessened the need for inventory levels to be so high. While that is true, I don't think it has anything to do with why U.S. inventory levels are being targeted to be lowered.

That said, the U.S. has been increasing imports because of the gradually declining oil supply in the U.S., and that means there is still some risk to have lower inventory levels, as it U.S. increases its reliance on it, even if it's far better than it has been in the past.

As it stands, the U.S. is less at risk to foreign disruption, but it still is exposed to it.

The positive is the change in the inventory policy in the U.S. could be interpreted as a nod toward feeling more secure with lower oil stockpiles. The negative is I have no illusions this is the impetus behind the new strategy.

Conclusion

The U.S. Department of Energy and the EIA are working toward lowering U.S. oil stockpiles. The only real reason for that is in order to manipulate the price of oil in order to provide some support for it.

Why that's happening is because the market has been putting a lot of weight on U.S. inventory as a key metric in the oil market, and reducing oil stockpiles would give the illusion it is being worked down, rather than pushed out into the market.

It's obvious this would cause short-term pain, but I also believe the strategy will backfire and bring more devastation to the market, because supply levels will continue to surprise to the upside. Under that scenario, if the agency requires levels to be artificially suppressed, it would mean oil being pressed into the market no matter what the conditions are.

As with the entirety of the oil sector, the only thing that will cause this scenario not to play out would be for demand to outpace the growth of supply. That is unlikely to happen until the end of 2017, if it does even then.

This is an important element that hasn't been part of the oil story. If the oil is forced into the market, the price of oil will plummet even further than I believe it will, which would result in it probably testing the high $20s once again.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.